Ukraine grasps for a measure of stability in presidential vote

Viktor Yanukovych and Yulia Tymoshenko will likely face off in second round

By

PolyaLesova

FRANKFURT (MarketWatch) -- Ukraine's upcoming presidential election may bring some measure of stability, but the deep economic crisis and the specter of more political volatility make this country a tricky place to invest.

No candidate is expected to win 50% or more of the votes in Sunday's election. The latest polls suggest that Viktor Yanukovych, seen as the pro-Russia candidate, and Yulia Tymoshenko, the prime minister, will likely face off in a second round.

Yanukovych is ahead of Tymoshenko in the polls, but given the high number of undecided voters, the result seems too close to predict. One thing seems certain, however: President Viktor Yushchenko, who led the so-called Orange Revolution of pro-democracy protests in late 2004, stands almost no chance of winning.

Tymoshenko, Yanukovych and Yushchenko have dominated Ukrainian politics in recent years, and the ongoing fights among them have spooked investors and largely paralyzed policy-making at a particularly dire economic time. The election is expected to abate some -- though not all -- of the political uncertainty in the country.

"We expect more stability," said Aivaras Abromavicius, Kiev-based partner at East Capital, which is currently invested in Ukrainian stocks.

"We're at a rock-bottom situation now with a very high cost of capital and still fragile banking system. Everyone realizes it all can change and improve when stability returns."

Ukraine, a country roughly the size of France, has a strategically important location between the European Union and Russia. Its economy contracted 15% in 2009, as demand for its key steel exports collapsed. The International Monetary Fund has provided a $16.4 billion aid package, but the fund recently suspended further loan disbursements because of Ukraine's failure to put in place tough economic reforms.

Investors have taken notice. As measured by CDS spreads, Ukraine is the second most likely country to default on its debt after Argentina, according to data from CMA Datavision. The local currency, the hryvna
USDUAH, +0.6882%
has been very volatile, but finished 2009 basically flat against the U.S. dollar. Other emerging-market currencies, such as the Brazilian real, however, posted strong gains.

Both Tymoshenko and Yanukovych "realize they seriously need to address corruption and they need to resuscitate the economy," said Lilit Gevorgyan, an analyst at IHS Global Insight in London. "They desperately need to restart negotiations with the IMF."

The IMF is particularly important, since Russia is not in a position to help its neighbor financially because of its own economic troubles, Gevorgyan said.

Under Ukraine's political structure, the president, to be effective, has to cooperate closely with the prime minister. Both Yanukovych and Tymoshenko lack sufficient support in the Ukrainian parliament, the Rada, to muster a majority, so a period of political uncertainty after the presidential election appears inevitable.

"We expect a difficult political battle during and after the election to trigger a new round of negative news flow," said Anastasia Golovach of Renaissance Capital in Kiev.

"Investors could decide to sell some instruments [stocks and bonds] because the stabilization of the political situation in unlikely in the short term," she said.

There is no significant ideological competition between Yanukovych and Tymoshenko, but Tymoshenko would be more positive for investor sentiment, because she seems to need less time to consolidate power and bring stability, according to a recent report by Renaissance Capital.

Impact on Ukrainian stocks

Ukraine's benchmark PFTS stock index rose 90% in hryvna terms last year after tumbling 74% in 2008. In dollar terms, the index rallied 83% in 2009, just as much as it dropped the previous year. Still, over the last decade, the index has surged 858% in dollar terms and 1,366% in hryvna terms, according to data from the PFTS Stock Exchange.

"Liquidity is very poor here, but if we have a stable political situation and a stable exchange rate for a few months, investors will start looking at this country," Abromavicius said.

The market capitalization of the PFTS, which consists of 20 companies, was $10.1 billion last year. The sectors that stand out are steel and iron ore, utilities and banks.

"Whoever wins the election, I really think it's going to be a positive watershed for Ukraine," said Jack Dzierwa, global strategist and co-manager of the $440 million Eastern European Fund at U.S. Global Investors. The fund had no investments in Ukraine as of last September.

"Having seen this rally last year, Ukraine -- considered one of the most risky markets - is not cheap, so you have to be selective and compare companies with their peers," especially in Russia, Dzierwa said.

Motor Sich, a manufacturer of aircraft engines, is one publicly traded company that investors should look at, observers say. Other potentially attractive firms include power generation company Centerenergo, Azovstal Iron and Steel Works, as well as Ukrtelecom, according to Dzierwa.

Investors can also get exposure through Ukrainian companies listed in London, such as Ferrexpo PLC (FXPO), a Swiss-based producer of iron ore pellets with assets in Ukraine, poultry producer MHP S.A. (MHPC) and London-based JKX Oil & Gas PLC (JKX), whose principal interests are located in Ukraine and Russia.

Oleksandr Zholud, senior analyst at the International Center for Policy Studies in Kiev, said that investors see Ukraine as a risky and high-margin market. He expects the IMF to disburse the next tranche of money after the presidential election.

"All [presidential] candidates offer some additional social spending, and there is no means to increase budget spending other than by increasing the deficit," he said, adding that the central bank may have to finance the deficit by printing money.

"The question is whether the National Bank [of Ukraine] will be able to keep its ground and try to preserve the stability of the domestic currency," Zholud said.

The stakes are high not only for Ukraine's population of 46 million, but also for foreign investors. A number of international firms, especially banks, have moved into Ukraine in recent years, mostly by buying up local assets.

Austria's Raiffeisen International
RAIFF, +2.03%
Hungary's OTP Bank, as well as France's BNP Paribas (BNP) and Credit Agricole SA (ACA) all have a local presence. Russian banks, such as state-owned Sberbank and private lender Alfa Bank, are also represented.

Global steel producer ArcelorMittal
MT, -6.38%
bought a major steel mill in 2005, while a Russian group is reportedly close to acquiring control of Industrial Union of Donbass, one of Ukraine's biggest steel companies.

"Ukraine is always promising," said Abromavicius of East Capital. "Let's hope that one day, sooner rather than later, it will live up to this potential."

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